The Short View: Political risk

[9.29.08]

At last, we have a black swan. The credit crisis began last year soon after the publication of Nassim Nicholas Taleb's bestselling Black Swan, which tackled the impact of unexpected events, such as the discovery of black swans in Australia by explorers who had thought all swans were white. ...

...Prediction markets, summing the market's wisdom, had it wrong. Last week, the Intrade market put the odds that the Tarp would have passed by now at more than 90 per cent.

Models using market extremes to predict political interventions were also fooled. When volatility rises as high as in the past few weeks, it has in the past been a great bet that the government will do something—which is in part why spikes in volatility tend to be great predictors of a subsequent bounce.

Taleb himself suggested recently that investors should rely least on normal statistical methods when they are in the "fourth quadrant"—when there is a complex range of possible outcomes and where the distribution of responses to those outcomes does not follow a well understood pattern.

Investors were in that quadrant on Monday morning. They were vulnerable to black swans and should not have relied on statistics as a guide.

One prediction for the future does look safe, however: investors will spend much more time making qualitative assessments of political risk.

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At last, we have a black swan. The credit crisis began last year soon after the publication of Nassim Nicholas Taleb[4]'s bestselling Black Swan, which tackled the impact of unexpected events, such as the discovery of black swans in Australia by explorers who had thought all swans were white. ...

...Prediction markets, summing the market's wisdom, had it wrong. Last week, the Intrade market put the odds that the Tarp would have passed by now at more than 90 per cent.

Models using market extremes to predict political interventions were also fooled. When volatility rises as high as in the past few weeks, it has in the past been a great bet that the government will do something—which is in part why spikes in volatility tend to be great predictors of a subsequent bounce.

Taleb himself suggested recently that investors should rely least on normal statistical methods when they are in the "fourth quadrant"[5]—when there is a complex range of possible outcomes and where the distribution of responses to those outcomes does not follow a well understood pattern.

Investors were in that quadrant on Monday morning. They were vulnerable to black swans and should not have relied on statistics as a guide.

One prediction for the future does look safe, however: investors will spend much more time making qualitative assessments of political risk.